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When traders complained to the CME Group about the pricing of Libor at the height of the financial crisis in 2008, the world's largest futures exchange worried about the benchmark's credibility and urged changes that would have effectively made it harder to accuse bankers of rate fixing.

In memos exchanged over the summer of 2008 -- some of which we report for the first time -- the futures exchange revealed clear concern that Libor's bank contributors might conspire to rig the benchmark. To the dismay of both groups, one of the sixteen bankers caught up in the Libor price-fixing scandal, Barclays (BARC), late last month paid fines and civil penalties totaling $450 million to the Commodity Futures Trading Commission and Department of Justice in the United States and the Financial Services Authority in Great Britain.

The Justice Department and Great Britain's Serious Fraud Office have since announced criminal investigations into suspected rigging of the London Interbank Offered Rate -- a benchmark for $350 trillion of swaps and $10 trillion of loans, and central to the CME's interest rate contracts. Banks are suspected of submitting false quotes to the daily Libor survey to disguise their own financial distress or benefit their trading positions in CME derivatives.

The scandal could also impact the CME's dominant share of trading in interest rate futures, if some traders migrate to non-Libor-based derivatives, such as the GCF Repo Index launched this week by rival
NYSE Euronext
(ticker: NYX).

Back in 2007 and 2008, several traders complained to the CME that the benchmark rate had been set at prices unaccountably far from where interest rate futures were trading in the pit. The CME -- concerned about its largest and most liquid interest rate contract -- responded to those complaints by signing a non-disclosure agreement with the BBA, allowing it to provide the bankers with confidential guidance for improving the Libor's calculation.

"When you start getting these phone calls [from traders], you're like, 'Okay, Houston, we have a problem,'" said Eugene Mueller, a former director of interest rate and credit product research at the CME from July 2007 through April 2009 who oversaw the matter as the complaints started to flow in.

Mueller took a flight to London and sat down for lunch with John Ewan, the BBA's then-Libor manager and now managing director of BBA LIBOR Ltd. The purpose of that lunch was to sign the non-disclosure agreement, said Mueller now managing director at Omega Financial Training, a Chicago-based consultancy.

Mueller returned to Chicago and his team of four economists looked at the BBA's Libor methodology, which involved surveying sixteen London banks daily and averaging the rate at which they said they could borrow in dollars.

The CME made three reform proposals to the BBA's governing body, which have not been made public before now: Expand the sample size of contributing banks from 16 to 31; use the median instead of the "trimmed mean" (a calculation of the mean after discarding outliers); reframe the question to focus on where the contributing bank thinks the fair rate is, rather than where they think they can borrow money at.

The BBA's Ewan didn't respond to Barron's emails seeking comment. BBA spokeswoman Eleanor Lavan was unable to comment on specific conversations, but said that the BBA held an open consultation on LIBOR in Spring 2008.

Mueller, for his part, was bound by a confidentiality agreement at the time.. "We were concerned, which is why we went directly to the BBA," Mueller said. "I don't think the CFTC thought it was within their jurisdiction."

Barron's has also reviewed a previously undisclosed letter that Frederick Sturm, the CME's director, sent to the BBA's John Ewan. From the evidence of the July 3, 2008 letter, the bankers and the CME seemed to think there was reason to think the benchmark was susceptible to manipulation.

In a section of the letter headed "Robustness against attempted wrongdoing," Sturm argued that a median-based average would be harder to rig than the mean-based Libor. "In the unlikely and unwelcome event that Contributor Panelists were to attempt to influence the outcome of the Libor fix" with the median, the CME figured that a conspiracy would take at least half of the 16 Libor contributing banks. With the mean, by contrast, only a quarter of the panel would suffice for a conspiracy.

The BBA had solicited Libor reform ideas in a public memo the preceding month, to which it received over 30 responses. That June 2008 memo from the BBA boasted that "transparency has long been one of the key attractions of Libor" and had proposed that Libor should itself investigate unusual rate quotes from a bank that were extreme enough to move the Libor average.

The CME's July 2008 letter cautioned that the BBA's plan for heightened self-surveillance would raise administrative costs and increase risks to the benchmark's credibility.

This last concern -- that catching dishonest bankers would discredit the important benchmark -- led the CME to suggest in its July letter that Libor change to survey questions that would let bankers give answers that were more, not less, hypothetical. Instead of asking "at what rate can your bank borrow]" -- the question that bankers like Barclays are now under investigation for answering dishonestly -- the CME letter suggested a less onerous hypothetical: "At what rate could prime banks borrow from each other."

The BBA characterized the CME's proposal as a "retrograde" step that would decrease Libor's transparency. Summarizing all submitted ideas, an August 2008 BBA memo said an idea like the CME's would make bankers' Libor quotes "less publicly accountable and less reflective of a panel bank's true borrowing costs."

The media might interpret such a change as an attempt by banks to hide their true borrowing costs from the public, the BBA concluded.

There's little explicit evidence in the 2008 year memos that the BBA worried that banks were trying to rig the benchmark. The Foreign Exchange and Money Markets Committee, a committee chaired by representatives from Libor-contributing banks, "believes that current submissions are accurate," said the August 2008 memo. "[A]ll contributing banks are confident that their submissions reflect their perception of their true costs of borrowing, at the time at which they submitted their rates."

On November 17, 2008, the Foreign Exchange and Money Markets Committee decided against most changes proposed by the CME. And most Libor users learned nothing of this 2008 debate, or the concerns that prompted it, because the proceedings were wrapped under the CME-BBA hush deal.

The non-disclosure agreement was "mutually beneficial," according to Mueller. "We were saying to the BBA, 'Listen, we have this franchise called Eurodollar futures, we use your number, your number's being complained about -- can we help you with this?'" CME spokesman Michael Shore declined comment on whether the self-regulated exchange even signed a non-disclosure agreement with the BBA.

But if in 2007 and 2008 the CME's concerns about the BBA's methodology for fixing Libor also rose to concerns about manipulation of Libor, it would have been appropriate for the CME to have contacted its regulator, the CFTC, said Darrell Duffie, a finance professor at Stanford Business School who has followed the Libor matter for several years. The CME's spokesman confirmed that the letter was sent to the BBA in 2008, but could not confirm whether it was also sent to the CFTC, or the Securities and Exchange Commission -- its other regulator. The CME also had no comment on whether it contact regulators about complaints received.

Congressman Randy Neugebauer (R-Texas), chairman of the House Financial Services Subcommittee on Oversight and Investigations, said his subcommittee is looking into the Libor matter "to determine who was involved in this practice and whether it could have been prevented by regulators." On Friday, Rep. Neugebauer forced the Federal Reserve Bank of New York to release its August 2007 -- November 2009 communications with Barclays regarding Libor. That correspondence also shows that regulators were concerned about the integrity of the banks' benchmark.

Investors could never be sure what a Eurodollar contract is worth, said Stan Jonas, who was a trader at the derivatives group at FIMAT/ Société Générale SA (ticker: GLE) when he complained to the CME and others that the pricing mechanism was flawed. "It was always an imaginary number," said Jonas, now at Axiom Management Partners LLC. The Libor isn't a traded number, but futures are traded securities, he said, "and the CME decided they would settle to that crazy average."

The Libor-based Eurodollar contracts are an important business for the CME. Eurodollar futures represent about 9% of total revenue, the CME spokesman said. From 2010 to 2011, the CME's total revenue also rose by 9%, to nearly $3.3 billion. If the scandal damages confidence in Libor, the market could take more heed of alternative benchmarks.